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Whether they are pulling together a complicated financing package for a hydropower dam half way around the planet or lending to a local chemical company down the street, banks are increasingly looking at the impact of their lending practices on the environment.

And it is not only the uncomfortable public scrutiny created by global activists protesting outside an unwanted logging mill in Indonesia or bank headquarters in downtown San Francisco that has more and more banks scrambling to create an environmental policy around their loans. Banks must increasingly worry about how the environmental activities of their corporate clients can affect their own credit risk.

“Banks are paying more attention to corporate social responsibility because they realize it’s good business...it can affect their bottom line and their financial statements,” says Sang Hwang, an analyst with SNL Finance in Charlottesville, Virginia.

Today, banks not only face the specter of an expanding portfolio of non-performing loans if their lending officers do business with environmentally careless companies that go belly up because of pollution clean-up costs; tougher environmental regulations also mean a financial institution could even be held responsible for the clean-up costs of a polluted site if the land owner or business owner is unable to ante up.

“Legislation can play a very important role in helping industry and banks move toward less polluting projects,” adds Hwang, who also holds a doctorate degree in environmental design and planning from Virginia Polytechnic Institute and State University in Blacksburg, Virginia. “The smart companies and the banks are aware of these situations. Paying attention to the environment makes good business sense, both from providing business opportunities and satisfying shareholders’ perception that corporations should be good stewards of the environment.”

Ilyse Hogue, global finance campaign director for the Rainforest Action Network in San Francisco, agrees that the greater attention emanating from bank customers and other stakeholders, as well as the costs associated with financing environmentally sensitive projects, are putting pressure on bank managers.

“If there is resistance to a project and concerns about its environmental impact, that can play out economically,” says Hogue, pointing to the huge cost overruns associated with controversial projects, such as the Royal Dutch Shell Sakhalin project. In July the giant energy company announced that the costs of its Sakhalin II project, which aims to tap into 4 billion barrels of hydrocarbons off the eastern coast of Russia, had doubled to $20 billion.

Hogue says the increased economic and public pressure is in turn gradually shifting the mindset of bank executives. “When they are forced to look more closely at the consequences of their lending decisions, they are inevitably examining the mark they are going to leave on the world,” she says. “In many cases, irresponsible lending can lead to environmental destruction and human injustice. No one wants to be responsible for that.”

“It’s a slow process, but there’s been a real sea change in the industry and a real shift in thinking,” Hogue adds, “but with that said, there’s still a long way to go.”

One of the most prominent displays of the global banking community’s greater attention to the environment is the Equator Principles. A voluntary set of guidelines for managing the environmental and social risks associated with financing large development projects like dams and oil pipelines, the Equator Principles were first adopted by 10 banks in June 2003. Today, more than 30 banks around the globe have signed on to the principles, which are modeled on the policies of the World Bank and the International Finance Corporation (IFC), the World Bank’s private sector investment arm.

Bulmer: There’s a shortage of capital

The principles use a set of specific mechanisms to help banks ensure that a development project they are financing won’t damage the environment excessively or disrupt the local community, such as by displacing indigenous people. The guidelines are voluntary and apply to projects with a total capital cost of $50 million or more.

Jon Sohn, a senior associate at the World Resources Institute (WRI) in Washington, DC, agrees that the Equator Principles are a good example of how the banking community is paying more attention to social and environmental concerns. But the next step is for financial institutions to develop techniques and tools to implement these principles and make the techniques transparent to stakeholders, he says. “There’s three categories [of banks that have signed on to the Equator Principles]: banks that have taken this to heart, like Citigroup; banks that are adopting and working through the implementation, like JPMorgan Chase; and the free riders,” says Sohn, adding that unfortunately many of the signatories fall into the third category.

The environmental and social lending policies at Citigroup, one of the original adherents of the Equator Principles, have been evolving over many years. But the bank made a greater commitment in 2003 when its corporate and investment bank unit released a formal policy called the Environmental and Social Risk Management Policy (ESRMP). Building on the Equator Principles, the policy is meant to help Citigroup address environmental and social issues from both a credit-risk perspective and a reputational- and franchise-risk perspective. Last year the bank created the position of ESRMP director in its corporate and investment bank unit. The director serves as a technical resource and counsel for the bank’s specialists on environmental and social risks, as well as advises other executives in the corporate and investment bank division. Shawn Miller holds the director’s slot and reports to John Gilliland, one of the company’s senior risk officers.

“This is a more structured way to address these issues. We’re managing our risk and responding to the public,” says Pamela Flaherty, senior vice president for global community relations at Citigroup, “but there is also an element of opportunity here to add value for our clients. We can help our clients be smarter about the environmental and social risks they face.”

Flaherty says the bank is not turning down any greater number of loans since its ESRM policy was adopted, and, in any event, bank officials do not believe that the denial of loans is any measure of success of whether their policies or the Equator Principles are effective. “We want to work with our clients on developing projects. By articulating a set of guidelines, our clients know what to expect,” explains Flaherty.

Signing on to the Equator Principles and adopting other similar policies can be seen simply as window dressing for the banks. Wells Fargo, for example, recently found itself in hot water when it announced a 10-point environmental commitment about two months ago. Critics said the bank’s commitment fell far short of the industry best practices set by other financial institutions such as Citigroup, JPMorgan Chase and Bank of America and did not include implementation details or a policy to back up the commitment.

The bank, a recent signatory to the Equator Principles, said the 10-point environmental program was meant to integrate environmental responsibility into its business practices and procedures. “It [the commitment] was better than nothing, but the content was weak,” says Hogue, adding that a planned protest outside the bank’s San Francisco headquarters went ahead as planned in mid-July. “We were protesting their lack of environmental commitment. We want to keep the pressure on,” she notes.

Flaherty: We’re managing our risk

Environmental groups are also keeping the pressure on the lending practices of multilateral development agencies. In a report released in June, the World Resources Institute recommended that multilateral development banks incorporate environmental and social policies into their lending practices to financial intermediary institutions in developing countries.

The report criticizes the multilateral institutions for making loans to so-called financial intermediaries, such as a local bank in Egypt, without fully assessing the effect that the local bank’s loan to a local business will have on the environment and community. The institute’s report comes out as the IFC is in the midst of updating its own safeguard policies—guidelines used to make sure the private business ventures it finances aren’t polluting the air or disrupting the homes of local people.

First adopted in 1998, the safeguard policies are based on the World Bank’s operational policies. The IFC has been working with other groups for some time as it reshapes the guidelines and will be accepting public comment, both oral and written, before the end of the year, an IFC spokesperson says. The agency hopes the revised guidelines are in place by the beginning of next year.

Sohn says the WRI believes the IFC safeguard policies do not pay enough attention to the loans given out by the local banks at the same time that these financial intermediaries are receiving a larger portion of IFC funds. For example, more than 50% of IFC loans in 2002 went to financial intermediaries in developing countries.

But IFC officials say they and the WRI have the same goal: insuring that the business ventures it finances follow environmentally sound practices. “We want the same thing, but it’s not possible to supervise every sub-project,” says William Bulmer, associate director of the environmental and social department at IFC in Washington. He adds that the IFC closely investigates the managing capabilities of the financial intermediaries.

The IFC has boosted its loans to the local financial institutions as a way to get more money to viable business projects. “There’s a shortage of capital to support grassroots development,” Bulmer says. “We have the capital but can’t always reach the small-scale businesses.”

Whether private or multilateral, financial institutions’ efforts to integrate the environment into their lending practices are here to stay, industry observers agree. “While the transformation may have been motivated by advocacy groups and outside pressure, the process of examining the real consequences of destructive lending policies has created real commitment in these banks,” says Hogue. “Wall Street is emerging as a leader on enacting solutions to these complicated and pressing problems. Still, we are far away from where we need to be, given the gravity of the global issues facing us in the 21st century.”